Toxteth, Liverpool, where rioting prompted ministers to consider a 'managed decline' during which residents would be encouraged to move elsewhere. Photograph: Sipa Press/Rex Features

Margaret Thatcher's closest ministers came close to writing off Liverpool in the aftermath of the 1981 inner-city riots and even raised the prospect of its partial evacuation, according to secret cabinet papers released on Friday.

They told her that the "unpalatable truth" was that they could not halt Merseyside's decline and her chancellor, Sir Geoffrey Howe, warned her not to waste money trying to "pump water uphill" and telling her the city was "much the hardest nut to crack".

The cabinet papers released by the National Archives under the 30-year rule reveal Thatcher's closest advisers told her that the "concentration of hopelessness" on Merseyside was very largely self-inflicted with its record of industrial strife.

The files show that when Michael Heseltine pressed the case to save Britain's inner cities with his cabinet paper, It Took a Riot, they ensured his demand for £100m a year of new money for two years for Liverpool alone was met with a paltry offer of £15m, with the condition that "no publicity should be given to this figure".

Although they never articulated the case publicly at the time, those telling Thatcher that there was little point in spending money on Liverpool also included the industry secretary, Sir Keith Joseph, and her Downing Street advisers, Sir John Hoskyns and Sir Robin Ibbs.

In a confidential note in the immediate aftermath of the Toxteth riots, Howe said that Heseltine's plans for a "massive injection of additional public spending" to stabilise the inner cities had to be rejected: "Isn't this pumping water uphill? Should we go rather for 'managed decline'? This is not a term for use, even privately. It is much too negative, when it must imply a sustained effort to absorb Liverpool manpower elsewhere – for example in nearby towns of which some are developing quite promisingly."

Howe told Thatcher that Heseltine's plan for a cabinet minister for every deprived region should be restricted to a one-year lone experiment in Merseyside after arguing that if there was any extra money he would rather spend it on the more promising West Midlands. He decried Heseltine's role as "minister for Merseyside" as an attempt by the latter to create a "godfather role" for himself.

The cabinet papers also disclose that the cabinet secretary, Sir Robert Armstrong, personally warned Thatcher that Heseltine, despite his undoubted "zest and panache'', was not the man to save Britain's inner cities arguing he was "distrusted and disliked in the local authority world". Armstrong suggested Jim Prior or Lord Soames would do a better job.

In his paper, Heseltine concentrated on the "devastating impact" of 30%-50% unemployment in some inner-city areas and described the outcome of postwar policy towards Merseyside as a "tactical retreat, a combination of economic erosion and encouraged evacuation".

Thatcher went to Liverpool and told community leaders she had come to listen. Her memoirs show that she did indeed listen to the views of some young people in the town hall but was so appalled by their bitter hostility to the police that she quickly starting begging them not to riot again.

They had complained that the cause of the riot lay in the police tactics of the Merseyside chief constable, Kenneth Oxford: "He believed in slapping people down and keeping them down," says the official record of the meeting. "The police had attacked the very community leaders who had tried to bring the riot to an end. They said the Liverpool police regarded anyone who was black as a criminal and acted accordingly."

When Thatcher complained to the archbishop of Liverpool, Derek Worlock, immediately afterwards about their "hatred of the police" he told her there was "a silent colour bar" operating in the city, saying there were only eight non-white police officers and neither councillors nor shop assistants from ethnic minorities.

But Thatcher said she was not concerned "about the colour of people's skins" and condemned the rioters as criminals. It was left to the Scarman inquiry to tackle the police racism that lay behind the complaints. The official papers confirm that the main response to the 1981 riots was to give forces better equipment and more powerful weapons.

The cabinet papers also show that a panicky Metropolitan police commissioner, Sir David McNee, told the prime minister at the height of the Brixton riots in July that he was unable to guarantee the security of the royal wedding of Prince Charles and Diana Spencer, which was due to take place the following month without the introduction of a modern-day riot act. He raised the stakes by telling her that he had already raised it with the Queen.

McNee presented Thatcher with a list of equipment he needed including riot shields, water cannon, rubber bullets and armoured vehicles – preferably painted blue rather than kept army grey, CS gas and even a "heli-telly" – an early mobile surveillance helicopter – during a midnight visit to Scotland Yard.

He said he was especially concerned about the arrangements for the planned royal wedding fireworks in Hyde Park which foreign dignitories would watch from a stand without any cover.

The government responded by immediately providing 1,500 Nato riot helmets from army stocks, asked the army to provide more baton rounds and six water cannon to the police and opened three army camps to be used as prison overflows.

A water cannon demonstration was also laid on but the use of troops was ruled out. "If necessary the police should be properly equipped and even armed, before such a step was taken," said the Downing Street note of a conversation between the home secretary, Willie Whitelaw, and Thatcher on 11 July when riots erupted in Moss Side, Manchester.

The minister finessed the demands for a new riot act but conceded that the police should be given the discretion to use rubber bullets and baton rounds for the first time in mainland Britain. In typical Whitelaw fashion he only made this concession after the chief constables had privately assured him that they would not use them.

The 1981 riots were Britain's worst urban riots of the 20th century, running from April to July and involving violent confrontations between mainly young black people and police in Liverpool, Manchester and parts of London including Brixton and Southall. More than 800 police were injured and more than 3,000 people arrested.

The disturbances came as Thatcher's early monetarist economic experiment plunged unemployment towards 3 million and her well-documented reaction to the first televised pictures of rioting and looting in Toxteth – "Oh, those poor shopkeepers" – illustrated the limited law and order nature of her response.

While she stood firm against Heseltine's attempt to create a traditional Tory drive to save Britain's inner cities, Whitelaw set about re-equipping the police with more modern helmets, shields and batons that would prove as important as building up coal stocks in Thatcher's showdown with the miners in 1984.